The fiscal cliff: tax the rich, cut the deficit, and grow the economy

As we approach the “fiscal cliff” President Obama is adamant about raising tax rates on high income families to help reduce the deficit. House Speaker John Boehner now says Republicans are willing to consider some form of higher tax revenue as part of the solution – but only “under the right conditions.” Lower tax rates for all families, both rich and poor, is one one of them. If the Republicans were to reconsider this position, the President and the Congress could pull off a pretty neat trick – simultaneously reducing the deficit and stimulating the economy.

How could this possibly work?

Right now, the main reason why economic growth is so sluggish is a lack of consumer spending. If we want to increase demand for goods and services, we need to put money in the hands of spenders, not savers. Savers are good for investment, but savings are not our current problem. Businesses are sitting on the sidelines with something like $2 trillion in cash which they could use for investment. They are not investing because in the current economy they fear there is not enough consumer demand to purchase the output this investment would produce.

Right now the nation needs consumers. So who consumes and who saves? This is well-known. In general, savers are rich people. A family in the top 1% of all earners (those with incomes in excess of $569,000) spends only about 49 cents out of every additional dollar while those in the top 5% spend 63 cents out of every dollar. The rest goes into savings accounts, the stock market, and hedge funds – which in the short run create virtually no jobs.

What about everyone else? Four-person families in the lowest quintile of incomes – the poorest 20 percent — earning up to $45,200 a year spend 99 cents out of every additional dollar. Families in the second quintile ($45,201 – $69,800) spend 91 cents while those in the middle quintile (earning up to $100,200) spend 89 cents.

A major reason why economic growth has been so slow over the past decade is that an enormously disproportionate amount of income flowed to the richest families in the country who saved much of their gains. Between 2002 and 2007, 87 percent of the increase in personal income went to the wealthiest 10 percent of all Americans. Thirteen percent went to everyone else. Even spending every dollar of the little additional income they earned, total consumption by the bottom three quintiles of the economy was insufficient to grow the economy fast enough or create enough jobs.

This suggests a straightforward way to grow the economy faster while reducing the federal deficit and not add to government spending. The math is pretty simple. If we transfer $1,000 from a rich household in the top 1% of the income distribution to a family in the first quintile, consumption falls by $490 for the rich household, but spending goes up by $990 for the low income family for a net increase in consumption of $500. Transferring $1,000 from that rich household to a family in the second quintile increases consumption by $420. A transfer to a middle quintile family boosts spending by $400.

So here’s the deal the White House should offer Boehner to help avoid the fiscal cliff.

President Obama and the Congress should agree to temporarily raise the maximum marginal tax rate for those in the top 5 percent of all earners from 35 percent to 50 percent. This would be equal to the maximum rate in 1985 when Ronald Reagan was in the White House.

Half of all the additional revenue garnered from this increase in the top tax bracket should be set aside to reduce the size of the federal deficit.

The other half should be transferred as immediate tax rebates to households in the bottom three income quintiles. Nearly 93 percent of these dollars will go into the spending stream.

This increase in the maximum tax rate on the richest families in the nation and the tax rebates for most others should remain in effect until the unemployment rate falls below 6 percent. Cutting the higher marginal tax rates on the wealthy when the economy is booming again will shift incomes to high savers who will help spur investment when new production capacity will be needed.

This plan could be part of a larger Grand Bargain that includes additional methods for reducing government expenditures and raising more revenue.

The beauty of this plan from a liberal perspective is that it provides a major new stimulus to the economy without increasing the federal deficit. The beauty of this plan from a conservative perspective is that it entails no new government spending out of the increased tax revenue.

Unfortunately, Mr. Boehner and his allies are so ideologically opposed to taxes that they will likely refuse to consider such a plan no matter how well it might work to help reduce the deficit and expand economic growth, ironically the two issues at the very center of their own standard bearer’s recent campaign for the Presidency.